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Catching a Falling Financial Knife

U.S. Economy Heading For the Rocks?

Economics / Recession 2008 - 2010 Jun 14, 2010 - 03:43 AM GMT

By: Gerard_Jackson

Economics

Best Financial Markets Analysis ArticleIf you read Reuters, Associated Press and the rest of the phony news outlets the US economy is on the mend and it's only a matter of time before happy days are here again. If you are one of the unemployed or underemployed things are indeed gloomy. And no wonder. The Wall Street Journal reports that in the first quarter not one venture-backed company went public. This hasn't happened since 1980. Adding to the economy's woes we find that of the 431,000 non-farm jobs created last month a mere 41,000 was in the private sector, less than 10 per cent. To top it off, manufacturing also started to slow.


So much for the wonders of big-spending government and its regulatory chains. Only now are some politicians waking up to the fact that the Sarbanes-Oxley legislation might be amounting to a massive ball and chain that is holding back an entrepreneurial led recovery. Making matters worse is Obama's impending blizzard of regulations and the accompanying paperwork that will swamp small and medium size businesses. If that's the economic anvil the coming tax increases will be the hammer. This is not a good time to be a small American businessman.

A while ago I pointed out that so long as there was sufficient capital and land to employ people there cannot be permanent widespread unemployment in a free market. Some Readers are demanding to know that if this is right then why is unemployment so high? Because in America the free market is being badly crippled -- and it's getting worse. The Democrats have no understanding of free markets nor do they care to obtain any. Their ultimate aim is not sustained economic growth -- without which there is no prosperity -- but sustained economic power for themselves, irrespective of the cost to the country. The massive spending programs and their contempt for the electorate is ample evidence of that fact.

Given this situation is it any wonder that the American economy appears to be heading for the rocks? But as any seaman will tell you the most dangerous rocks to navigate are always those below the surface. The same can be said of the US economy. What bothers me -- and it applies to all other economies -- is not dismal economic indicators but the dismal level of the economic knowledge of millions of Americans. Although the great majority instinctively lean to free enterprise it cannot be denied that leftist thinking has greatly influenced public opinion.

This is why so many Americans can favour more controls on business while still favouring free enterprise. They have yet to see that this amounts to saying business needs to be increasingly chained in order to make it freer and more efficient. Needless to say, there will always be an ample supply of what Adam Smith aptly called "that insidious and crafty animal, vulgarly called a statesman or politician" to encourage this misguided line of thinking.

And this is what we are really facing: misguided thinking. Right across the intellectual spectrum we find ancient economic nostrums being flaunted as deep economic insights that can restore prosperity if only the state had the will to implement them. One of these nostrums is that government spending is the true road to recovery. It isn't and it never was. Pushed too far government spending can actually destroy an economy.

Robert Reich is Professor of Public Policy at the University of California at Berkeley and an excellent reason why you should keep your children away from a university. Recessions always bring forth an abundance of economic cranks and he is no exception. Unfortunately much of what he has to say can be found in the standard textbook. He stated on his blog that:

Why are we having such a hard time getting free of the Great Recession? Because consumers, who constitute 70 percent of the economy, don't have the dough. They can't any longer treat their homes as ATMs, as they did before the Great Recession.

This used to be called the underconsumption fallacy and was rightly treated with contempt by the classical economists* who understood what the great majority of contemporary economists apparently cannot: and that is that production pays for itself. In other words, demand springs from production, meaning that the means to produce always supplies the means to buy. Supplies constitute demands, as they used to say in the nineteenth century.

The only time this relationship appeared to breakdown is when, as the older economists put it, production was deranged. This was the result of investment expanding disproportionately to consumption, and was considered a monetary phenomenon. Unfortunately in the 1840s the early wisdom was superseded by what one might call the Wilson-Mill "irrational exuberance" theory in which the monetary component dropped out of sight. This was followed in the 1930s by the even worse Keynesian theory. And now look where we are.

But it goes without saying that Reich's opinion is not only plausible but self-evident. Is it not a fact that consumer spending makes up about 70 per cent of GDP? Yes it is. However, GDP is not a true measure of total economic activity because it omits intermediate spending on the spurious grounds that to include it would amount to double-counting. But once we do include it consumer spending drops to about one-third of total spending, indicating that business spending is what really drives the economy.

Focusing on the 70 per cent statistical fiction leads to the conclusion -- though it is rarely if ever stated -- that the US is a two-stage economy: the production stage and the consumption stage. Even on the surface this is a ridiculous view. No one denies that production takes place in stages and through time. What is being overlooked by the mass of today's economists is the enormous ramifications of this fact, one of which is that encouraging consumer spending can retard recovery and weaken production. There was a time when this fact was never a matter of contention. During the Great Depression it was noted:

The larger number of payments is not from consumers to producers, but is made between producers and producers, and tends to cancel out in any computation of net incomer of net product value. "In fact, income produced or net product is roughly only about one-third of gross income." [Italics added]. What is cost for one producer is in part income for some other producer, but part of that income the latter has to pay out in costs to other producers in another stage of the productive process (for intermediate products, raw materials, supplies, etc.), and so on. All that is necessary in order that equilibrium be maintained is that consumers' incomes equal the cost of producing consumers' goods; the total of producers' payments necessarily exceeds that of consumers' incomes. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 71).

In English so plain that even Mr Reich can understand it: consumer incomes are always exceeded by total expenditure on production. If Reich and the rest of the economic commentariat were right every economy in the world would be permanently and irredeemably depressed because there is no way that consumer incomes can ever equal or exceed total production costs.

If the public had -- or at least the country's economic pundits -- a far better understanding of how the economy functioned Obama's destructive economic policies would never have got off the ground.

*Malthus can be considered the exception, though in his later years he paid far less attention to the problem of depressions. His writings on the question of universal gluts conveyed to me the impression that he failed to fully grasp what proponents of what became known as Say's law were actually saying. See Say's Letters to Malthus as well as Ricardo's defence of Say's law.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2010 Gerard Jackson

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Catching a Falling Financial Knife